Effective for plan year beginning on or after January 1, 2013, an employee must limit salary reduction to no more than $2,500 in contributions to medical care flexible spending arrangements1.
Background
A cafeteria plan (“Cafeteria Plan”) is an employment based written plan maintained for employees that meets the specific requirements of IRC § 1252. A Cafeteria Plan permits participants to elect among one taxable (i.e. cash) and one qualified benefit. The written plan document must specify rules for eligibility and elections and all qualified benefits.
Participants are able to receive qualified benefits on a pretax basis. A qualified benefit is a benefit that does not defer compensation yet is excludable from an employee’s gross income. Qualified benefits include:
- Accident and health benefits3 (but not Archer medical savings accounts or long-term care insurance);
- Adoption assistance;
- Dependent care assistance;
- Group-term life insurance coverage;
- Health savings accounts, including distributions to pay long-term care services.
Contributions to the Cafeteria Plan are made pursuant to salary reduction agreements between the employer and the employee in which the employee agrees to contribute a portion of earned wages on a pre-tax basis to pay for the qualified benefits. Salary reduction contributions are not actually or constructively received by the participant. Therefore, those contributions are not considered wages for federal income tax purposes and thus are not subject to FICA and FUTA. Contributions made by an employer can be excluded from employees’ gross incomes.
A flexible spending arrangement (“FSA”) is a form of cafeteria plan benefit, funded by salary reduction, that reimburses employees for expenses incurred for certain qualified benefits. An FSA may be offered for dependent care assistance, adoption assistance, and medical care (“Health FSA”) reimbursements. A Health FSA may only reimburse certain substantiated section 213(d)4 medical care expenses incurred by an employee or by an employee’s spouse or dependents. The annual contribution limit into a Dependent Care FSA is $5,000 for each plan year; and the limit is reduced to $2,500 for married employees filing separate returns.
The benefits are subject to an annual “use-it-or-lose-it” rule. A cafeteria plan may include a grace period of up to two months and 15 days immediately following the end of a plan year. If the plan provides for a grace period, an employee may use amounts remaining from the previous plan year (including amounts remaining in a Health FSA) to pay for expenses incurred for certain qualified benefits during the grace period.
New Rule, New Limit
§ 9005 of the Patient Protection and Affordable Care Act added § 125(i). It states that a Health FSA is not treated as a qualified benefit unless the cafeteria plan “provides that an employee may not elect for any taxable year to have salary reduction contributions in excess of $2,500 made to such arrangement.” The new $2,500 limit on health FSA salary reduction contributions applies on a plan year basis and is effective for plan years beginning after December 31, 2012.
- $2,500 limit will be indexed for cost-of-living adjustments for plan years beginning after December 31, 2013.
- The plan year may only be changed for valid business reasons, and to alter the plan year in order to delay the application of the new $2,500 limit is not considered valid.
- For a cafeteria plan with a short plan year, the new $2,500 limit must be prorated.
- Regardless of the number of other individuals covered by the employee(i.e., a spouse, dependents, or adult children), the $2,500 remains the maximum salary deferral limit during a plan year.
- If each of two spouses is eligible to elect salary reduction contributions to a Health FSA, each spouse may elect to make up to $2,500 in salary reduction contributions to his or her Health FSA, even if both participate in the same Health FSA sponsored by the same employer.
- An employee employed by two or more employers that are not members of the same controlled group may elect salary reduction contribution up to $2,500 under each employer’s Health FSA.
- Employer non-elective contributions, also known as “flex credits” are not subject to the new $2,500 limit. An employer may make flex credits available to employees who are eligible to participate in the cafeteria plan, to be used (at their discretion) for one or more qualified benefits and not as cash or other taxable benefits.
- The maximum amount of reimbursement from a Health FSA must be available at all times during the period of coverage. The uniform coverage rule does not apply to FSAs for dependent care assistance or adoption assistance.
Conclusion
The new section 125(i) imposes a limit to Health FSA under a written employer cafeteria plan with plan years beginning after December 31, 2012. Employer must amend their existing plan document to reflect this change on a prospective basis. Just to be clear, this new regulation does not limit or affect the amount permitted for reimbursements under other employer-provided coverage, such as:1) contributions to an FSA for dependent care assistance, 2) contributions to an FSA for adoption care assistance, 3) payment of an employee’s share of health coverage premiums (i.e. premium conversion), 4) a health savings account (HSA), or 5) a health reimbursement arrangement (HRA).
This document is provided as an informational summary regarding the subject matter by Chao & Company, Ltd. and it is intended for general information purposes only and should not be considered or perceived as benefit, legal, tax or regulatory advice. The contents are neither an exhaustive discussion nor do they purport to cover all aspects or developments related to the subject matter. Chao & Company, Ltd. has no obligation to update this document further. Readers should consult with their legal counsel, tax advisor and benefit consultants to determine how this subject matter may relate to or impact their specific situations.
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- IRS Notice 2012-40 http://www.irs.gov/pub/irs-drop/n-12-40.pdf
- http://www.law.cornell.edu/uscode/text/26/125
- Y2011 Publication 969 http://www.irs.gov/pub/irs-pdf/p969.pdf
- http://www.law.cornell.edu/uscode/text/26/213